Execution

Monetary Policy

Monetary policy is the decisions and actions taken by a central bank to achieve its goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. In the U.S., for example, the Federal Reserve is guided in its monetary policy by its mandate from Congress, which is to promote "maximum employment, stable prices, and moderate long-term interest rates."[1] Most central banks around the world, such as the European Central Bank, the Bank of England and the Bank of Japan, largely have the same priorities.

The main mechanism available to central banks for executing monetary policy is influencing the level of interest rates—i.e., the cost of money—and the amount of money available to lend to businesses and consumers.

An "easy" or "accommodative" monetary policy means the central bank is keeping interest rates low and trying to make more money available in order to encourage economic activity.

However, if the central bank deems that the economy is growing too fast, which can create hyperinflation, it "tightens" monetary policy by raising rates and restricting the flow of money available for lending.

Central banks execute monetary policy through a variety of pronouncements of their intentions as well as actions in the marketplace to implement those goals.[1]

In the U.S., for example, the Federal Open Market Committee (FOMC) is the Fed's monetary policymaking unit. It sets the federal funds rate, its benchmark interest rate, which is the interest rate banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate has a profound effect on the general level of interest rates for businesses, consumers and governmental entities throughout the economy, both short- and long-term.

The FOMC is composed of 12 members. These are the seven members of the Fed's Board of Governors and five of the 12 presidents of the regional Federal Reserve banks, one of whom is the president of the Federal Reserve Bank of New York, and vice chairman of the committee and a permanent member. The chairman of the Fed is also the chairman of the FOMC. The presidents of the other regional Fed banks take turns filling the remaining four voting seats.

The FOMC has eight scheduled meetings a year, at which the members discuss current and expected economic conditions and decide to raise, lower or hold steady the fed funds rate, which it announces to the public. In between meetings, Fed members often try to influence interest rates through speeches, Congressional testimony, media interviews and other public pronouncements.[2]

Implementing Monetary Policy

In addition to these public pronouncements, the Fed has three tools to implement its monetary policy: open market operations, the discount rate, and reserve requirements. The FOMC is responsible for open market operations, while the Fed board of governors is responsible for the other two functions.

Open market operations (OMOs), which are conducted through the New York Fed, include the purchase and sale of securities by the Fed in the open market. There are two types of OMOs: temporary and permanent.

The Fed uses temporary OMOs to keep the fed funds rate in the target range established by the FOMC. These consist of either repurchase agreements (repos) or reverse repurchase agreements (reverse repos or RRPs). In a repo, which is essentially a collateralised loan, the Fed buys a security, usually a Treasury bond, and agrees to sell it back to the owner at a specified higher price. The Fed does this to add temporary reserves to the financial system. In a reverse repo, the Fed sells a security and agrees to buy it back later, in effect draining reserves from the system.[3]

Permanent OMOs involve outright purchases or sales of securities for the Fed's portfolio. During and after the financial crisis, after it had cut the fed funds rate to zero with little effect on the economy, the Fed bought trillions of dollars of U.S. Treasury securities and government-insured mortgage-backed securities in order to try to drive down long-term interest rates in the overall market and to make financial conditions more accommodative. The Fed has stopped its purchases of these securities and is reducing its portfolio by allowing those bonds to run off as they mature.[3]

The Discount Rate And Reserve Requirements

In addition to the fed funds rate, the Fed sets the discount rate. This is the interest rate commercial banks and other depository institutions pay to borrow from the Fed's regional banks, which banks use as a backup source of liquidity. By lowering the discount rate, the Fed makes it cheaper to borrow, thus encouraging lending and spending by consumers and businesses. Raising the discount rate should have the opposite effect by making borrowing more expensive.

The Fed is also empowered to set banks' reserve requirements, which are the amount of deposits that banks must hold in cash, either in their vaults or on deposit at their regional Fed bank. By lowering the reserve requirements, banks have more money to make loans, while raising them has the reverse effect.[4]

The Money Supply

The Fed also has some level of control over the amount of money circulating in the economy, which can also impact interest rates. An abundant supply of money generally equates with low interest rates, while a tighter supply would make it more expensive to borrow.

The Fed has "complete" control over one part of the money supply, namely the monetary base, which is currency in circulation plus banks' reserve balances held at the Fed. The Fed controls the monetary base through open market operations. By buying securities, it adds to bank reserves and increases the monetary base, which generally has the effect of lowering interest rates. Conversely, by selling securities, the Fed decreases a bank's balance at the Fed and thus the amount of money it has to lend to the public, which makes borrowing costs more expensive.[5]

Compared to the past, the money supply has lost some of its importance as a guide for central banks, including the Fed, to conduct monetary policy. The FOMC still takes money supply data into consideration while conducting monetary policy, but only uses it as "part of a wide array of financial and economic data."[6]

Summary

Monetary policy is the means by which central banks try to achieve their goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. They do this through a combination of raising and lowering interest rates and open market operations, buying and selling securities to increase or decrease the amount of money available for lending. An "easier" or "accommodative" monetary policy consists of low interest rates and abundant money for lending, while a "tighter" or "restrictive" policy means higher rates and less money for lending in order to choke off inflation.

Trade Oil Directly from Charts

Free Practice Account

Get Free $5,000 trading account

First Name *

Last Name *

Email *

Country *

Mobile Phone

Upon submission, I agree that FXCM may provide me with products, services, promotional offers and educational information by telephone, SMS or email. I understand that I will have the opportunity to opt-out of these communications after sign up. Please refer to our Privacy Policy.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites contained on this website are provided on an "as-is" basis, as general market commentary and do not constitute investment advice. The market commentary has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and it is therefore not subject to any prohibition on dealing ahead of dissemination. Although this commentary is not produced by an independent source, FXCM takes all sufficient steps to eliminate or prevent any conflicts of interests arising out of the production and dissemination of this communication. The employees of FXCM commit to acting in the clients' best interests and represent their views without misleading, deceiving, or otherwise impairing the clients' ability to make informed investment decisions. For more information about the FXCM's internal organizational and administrative arrangements for the prevention of conflicts, please refer to the Firms' Managing Conflicts Policy. Please ensure that you read and understand our Full Disclaimer and Liability provision concerning the foregoing Information, which can be accessed here.

Demo Account: Although demo accounts attempt to replicate real markets, they operate in a simulated market environment. As such, there are key differences that distinguish them from real accounts; including but not limited to, the lack of dependence on real-time market liquidity, a delay in pricing, and the availability of some products which may not be tradable on live accounts. The operational capabilities when executing orders in a demo environment may result in atypically, expedited transactions; lack of rejected orders; and/or the absence of slippage. There may be instances where margin requirements differ from those of live accounts as updates to demo accounts may not always coincide with those of real accounts.

Risk Warning: Our service includes products that are traded on margin and carry a risk of losses in excess of your deposited funds. The products may not be suitable for all investors. Please ensure that you fully understand the risks involved.

More Resources

Custom Service

FXCM Policies

Follow Us

High Risk Investment Warning: Trading foreign exchange and/or contracts for difference on margin carries a high level of risk, and may not be suitable for all investors. The possibility exists that you could sustain a loss in excess of your deposited funds and therefore, you should not speculate with capital that you cannot afford to lose. Before deciding to trade the products offered by FXCM you should carefully consider your objectives, financial situation, needs and level of experience. You should be aware of all the risks associated with trading on margin. FXCM provides general advice that does not take into account your objectives, financial situation or needs. The content of this Website must not be construed as personal advice. FXCM recommends you seek advice from a separate financial advisor.

FXCM Markets is not subject to the regulatory oversight that governs other FXCM entities, which includes but is not limited to Financial Conduct Authority, and Australia Securities and Investment Commission. FXCM Markets is not intended to be used by residents of: the United States, Canada, European Union, Japan, Hong Kong, or Australia. FXCM Markets is committed to maintaining the highest standards of ethical behaviour and professionalism as well as a high level of trust and confidence, all of which are pillars of FXCM's corporate culture. FXCM has earned a reputation for fairness, honesty, and integrity, and considers this to be our most valuable corporate asset. We recognize that our reputation hinges on the adherence of our employees to the highest standards of ethical behaviour and professionalism in the performance of their duties, without which our history of accomplishments would not have been possible. For more information please contact us.

All services and products accessible through the site www.fxcm.com/markets are provided by FXCM Markets Limited with registered address Clarendon House, 2 Church Street, Hamilton, HM 11, Bermuda.

The FXCM Group is headquartered at 20 Gresham Street,
4th Floor,
London EC2V 7JE,
United Kingdom.